Who benefits from a $ fall or appreciation Who benefits or loses

1
Who benefits from a fall or appreciation? Who
benefits or loses?

• When a currency depreciates (appreciates),
  domestic goods become relatively less (more)
  expensive compared to foreign goods.
• However, this is not always the case as many
  exporting companies do not change their prices,
  when exchange rates change, but instead absorb
  the costs (or profits).
• How does the exchange rate affect a firms
  profits? What factors affect it?

2
Introduction

• For example, between Jan 1994 and April 1995, the
  Japanese yen appreciated by 34 against the
  dollar.
• We would therefore expect the price of Japanese
  products sold in the US to be about 34 more
  expensive as a result of the appreciation of the
  yen. The price of Toyota Celica made in Japan
  increased by only 2
• The price of large-screen SONY Trinitron fell by
  15
• What happened?

3
Toyota Profits

• May 08, Toyota predicts net income will drop to
  1.25 trillion yen in the year started April 1,
  from a record 1.72 trillion last year. Operating
  profit may fall 30 to 1.6 trillion yen. The
  stronger Japanese currency will probably trim 690
  billion yen from operating profit, as the yen
  increased 15
• Dec 08 , Toyota announced 21 yoy will result in
  2.3 billion.
• Analysts say a one-yen appreciation of the
  Japanese currency against the dollar, for
  example, reduces Toyota's earnings by 450
  million a one-yen appreciation against the euro
  costs 80 million. The yen is currently at 98.2
  to the dollar, 1.8 yen stronger than Toyota's
  100-yen forecast. Against the euro the yen is at
  126.5, compared with a projection of 130.
• Jan. 09 Nintendo, which makes about 90 of its
  income overseas, said its performance was
  "adversely impacted by a large exchange loss due
  to the sharp appreciation of the yen.
• A 10 appreciation leads to a 1/3 drop in
  profits.

4
Exchange Rate Pass Through

• The percentage change in local currency import
  prices resulting from a one percent change in the
  exchange rate between the exporting and importing
  countries
• In the language of ERPT, a theoretical
  one-for-one response of import prices to exchange
  rates is known as full or complete ERPT

5
Full ERPT

• Full ERPT occurs when,
• There are constant markups of price over cost
• Constant marginal costs
• Perfect competition

6
Incomplete ERPT

• However, if market is monopolistically
  competitive, then ERPT isnt complete. Some or
  all of the impact of the change in interest rates
  on prices is swallowed by producers pricing
  decisions.

7
Incomplete ERPT

• Some research findings
• Pass-through to U.S import prices 50
• Pass-through to Germany 60
• ERPT to Japan 70
• ERPT to Belgium 90
• Kreinin (1977)
• Recent evidence is pass-through 20-30 inUS
• - Reflection of incomplete adjustment during the
  sample period or largeness of the importer in
  the sense of being able to influence world price.

8
Incomplete ERPT

• The previous results imply that 50 of the
  exchange rate change was offset by changes in the
  markup in the case of US imports, 40 of Germany
  imports, etc.
• Rise of imperfect competition led researchers to
  estimate ERPT at the industry level.
• Results varied across different industries

9
Incomplete ERPT and Markup

• Industry-specific estimates are different due to
  differentiated markup adjustment across
  industries.
• Why would markup adjustments be different?

10
Pricing to Market (PTM)

• Differences in demand curvatures explains the
  difference in markup adjustments in different
  industries.
• Moreover, a change in the exporters exchange
  rate can affect the price charged in two ways
• By affecting marginal costs
• By affecting the elasticity of demand

11
Pass-Through
How do changes in exchange rates affect prices
charged by foreign in the domestic market?
Price of Japanese Cars Sold in U.S.
Invoicing?
Exchange Rate
Revenue in
150/
20,000/auto
3,000,000/auto
Complete Pass-through
100/
30,000/auto
3,000,000/auto
20,000/auto
2,000,000/auto
100/
No Pass-through
Complete pass-through ? Toyota maintains
profit/unit in
12
How complete is pass-through?
1991-95 prices of imports from Japan rose by
20 while the Yen appreciated by 60
1995-98 same elasticity during yen depreciation
Why is pass-through so incomplete?
13
Theory of Incomplete Pass-Through
2. Segmented Markets (not integrated)
Resale across markets is limited so that nearly
identical products sell for different prices in
two markets without inducing profitable
third-party arbitrage.
price of Celicas in Japan 3,000,000
price of Celicas in U.S. (100/)(20,000/au
to)
2,000,000
How could you arbitrage this?
Impact on Prices?
Why is this arbitrage not possible in practice?
- tariffs at the border
- different environmental and safety standards
- warranties and service linked to location of
purchase
14
Discussion Question
You are a U.S. producer selling goods in Japan
and the U.S. Originally E 110 /. Price was
1 per unit of output in both markets. Now, E
120 /. Your () costs remain the same.
What qualitative suggestion (increase or decrease
dollar prices) would you make about how to
change prices in the two markets?
15
Monopoly Pricing

To maximize profit, the monopolist chooses q
where MR MC.
p
MC
D
MR
q
quantity
16
Standard Monopoly Pricing Example
Demand p 100 - 4 q Cost TC 100 10q
TR pq (100 - 4q)q 100q - 4q2 MR
(dTR/dq) 100 - 8q MC (dTC/dq) 10
MR MC ----gt 100 - 8q 10 ---gt q (90/8)
11.25
17
Deriving the Home Currency Foreign Demand Curve
Assume demand in Japan in en is p 2200 -
110 q
At E 110 en/, demand in is given by p
(2200/110) - (110/110) q 20 - q
Once we get demand and cost in a common currency,
this becomes a standard monopoly pricing
problem.
18
Foreign Demand in the Exporters Currency
20
price
Japanese demand at E 110 en/ p 20 - q
quantity
19
Foreign Demand Response to an Appreciation of the
Exporters Currency
At E 110 en/, demand in is given by p
(2200/110) - (110/110) q 20 - q
At E 120 en/, demand in is given by p
(2200/120) - (110/120) q 18.3 - 0.917 q
Demand in the exporters currency rotates inward
from the
x-intercept.
20
Foreign Demand Response to an Appreciation of the
Exporters Currency
20

quantity
21
Foreign Demand Response to an Appreciation of the
Exporters Currency

optimal price and quantity fall as a result of
appreciation of the exporters currency for a
given MC
p1
MC
MR1
quantity
q1
22
Response to appreciation

• Cut price (profit margin) to Japanese buyers to
  offset some of the currency swing.
• Reduce quantity sold (market share).
• Profits fall.
• Yen price faced by Japanese buyers still
  increases, unless you absorb 100 of currency
  change in margins.

23
Optimal Price Adjustment

• Profit maximization usually implies export price
  reduction (increase) to offset part of export
  currency appreciation (depreciation).
• The optimal adjustment must tradeoff market share
  and profit margins. Precise mix depends on
  market structure and demand.
• Even with optimal adjustment, operating profits
  will be affected by a change in the exchange
  rate, all else equal.

24
International Price Discrimination

• When possible, firms should segment buyers in
  different markets and charge optimal prices to
  each group.
• If demand conditions vary by market, then optimal
  prices will vary by market.
• In some cases, wide differentials can be
  maintained. Example--drugs.
• Arbitrage may limit discrimination.

25
Key Issues for Intl Price Adjustment

• What determines the desired mix of margin and
  share adjustments?
• Demand characteristics...
• Can the markets be segmented?
• Are there long term consequences of changing
  prices?
• How will competitors respond?
• Is the exchange rate change likely to be reversed?

26
Discussion Question
Honda Motor claims that every en the dollar
rises against the Japanese currency adds about
40 million to its profits. Why is Hondas
profit related to the strength of the dollar?
Is this a big deal or a small deal?
27
Price and Output Response to a Depreciation of
the Exporters Currency
en
optimal price and quantity rise as a result of
depreciation of the exporters currency for a
given MC
p1
MC
MR1
quantity
q1
28
Profit Response to a Depreciation of the
Exporters Currency
en
depreciation of exporters currency increases
price, quantity, and profit
p2
p1
MC
quantity
q2
q1
29
Is this a big deal for Honda??
30
en/ in the 1990s Implications for Hondas
Profits
1990 to 1995 150 en/ to 90 en/ Profit
change (40 mill)(-60) -2.4 billion
1995 to 97 90 en/ to 125 en/ Profit
change (40 mill)(35) 1.4 billion
31
Profit Response to a Depreciation of the
Exporters Currency

• Hondas profit is positively related to the value
  of the dollar.
• This effect is conditional on all else equal. In
  particular, other prices and wages in the U.S.
  and Japan are held fixed.
• It is not clear what assumption Honda is making
  in their claim

32
Currency Swings and Profits All Else Equal??
We saw that in the long run, prices and currency
movements are related by PPP. If an
exchange rate change is offset by inflation
differential, then no real effects should occur.
Inflation boosts local currency demand, but
export currency appreciation shifts foreign
demand in.
33
The Real Exchange Rate

• Exchange rate fluctuations that are not offset by
  inflation differentials imply movements in the
  real exchange rate.
• Real exchange rate changes are what give rise to
  exposure to currency risk.
• For the major industrialized economies, nominal
  and real exchange rates behave very similarly.

34
Real en/ (en/) (Pus/Pj)
35
Firm That Imports Inputs

• Suppose your firm only sells in domestic markets.
• But your inputs are priced in foreign currency.
• You buy inputs priced in yen, and sell in U.S.
  market. The exchange rate rises from E 110
  en/, to E 120 en/.
• The dollar price of your imported inputs falls.
  This leads to a decline in the marginal cost.
• Your firm should lower price and increase
  quantity sold.

36

Depreciation of yen lowers dollar marginal cost.
Margin increases and market share increases.
p
p'
MC
MC'
quantity
Q'
Q
37
Discussion Question
Do you think a one-yen rise in the value of the
dollar has an impact on the market value of
Honda that is greater than or less than 40
million?
38
Market Value and Currency Fluctuations

• A one-yen depreciation raises current period
  profit by 40 million.
• If it persists, it must raise next periods
  profit by a similar amount, all else equal.
• Market value should equal pdv of expected future
  free cash flow.
• Thus, the market value effect will exceed the
  current period profit effect.

39
Discussion of Weak Greenback

• How are MacDonalds profits affected by a
  weakening of the dollar?
• What do you predict will happen to euro prices of
  Big Macs?
• How might a Wisconsin manufacturer who does no
  international trade benefit from a weaker dollar?

40
How important is the Yen/ for Kodak?
41
Discussion Question
Should Honda consider hedging currency risk? What
kind of financial policies could help Honda hedge
its currency risk?
42
Hedging FX Risk

• Hondas profit and market value are positively
  related to the value of the dollar.
• The value of the dollar is outside Hondas
  control.
• Financial policies or investment decisions could
  reduce the sensitivity of Hondas cash flows to
  currency changes.

43
Should companies hedge FX risk?
Hedging makes sense only if it can improve
the value of the firm.
If capital markets are perfect, there may
be no reason to hedge risk.
44
Arguments against hedging

• Shareholders can diversify risk themselves.
• Hedging is costly. Bid-ask spreads can be wide
  and it requires managerial attention.
• Hedging equity risk can be very complex and
  require large positions.
• Hedging equity risk may appear to be speculation.

45
Arguments for hedging

• It is more costly for shareholders to diversify
  risk than it is firms.
• Asymmetries in the tax code favor stable profits.
• Hedging can lower the expected costs of financial
  distress.
• Hedging can affect future investment decisions in
  RD intensive industries.

46
What could Honda do to hedge FX risk?

• Hondas core business benefits from a strong
  dollar. How to offset?
• Short the dollar in forward market.
• Borrow in U.S. dollars rather than Yen.
• Incur more costs in the U.S. to reduce net
  exposure (real hedging).

47
Hedging FX risk

• The general idea is that when your firm has an
  asset denominated in foreign currency, it is wise
  to acquire a liability in foreign currency.
• The asset may be some future cash flow in foreign
  currency.
• The liability may be costs of production or debt.
• It is important to match the timing of the
  payoffs on the assets and liabilities.

48
The Wrap

• Currency fluctuations create a need for export
  price and output adjustment.
• Even with optimal adjustment, profits and market
  value are affected by a currency change, all else
  equal.
• In cases where exposure to currency risk is
  large, firms may want to hedge in order to reduce
  tax liability, avoid costs of financial distress,
  or maintain RD spending.